Question 2 (a)
Cash flows of a plant replacement decision
8 marks
- Time to write
- About 16 minutes
From an older CBCS paper
Question
Question 2 (a) · 8 marksLakshya & Co. is contemplating a proposal to replace one of its plants costing ?1,50,000 and having a written down value of ₹60000. The plant has a remaining economic life of 4 years, after which it will have no salvage value. If it is sold today, however, it has a salvage value of ₹45,000. The new machine, costing ₹3,20,000, is likewise expected to have a life of 4 years and a scrap value of ₹42000. Owing to its technological superiority, the new machine is expected to contribute an additional annual benefit (before depreciation and tax) of ?1,50,000. Determine the cash flows connected with this decision, given that the firm is subject to a tax rate of 35%. (Capital gain or loss may be treated as not subject to tax.)
Reworded from the university paper: names and figures differ, the task is the same. The original paper belongs to the University of Delhi. See DU's question bank.
Before you write
Read off the question and its marks
Read from the question
- is contemplating a…?A yes-or-no question: answer it in your first line, then explain why.
- DetermineFormula first, then the working, then the answer with its unit (₹, %, units).
What the paper leaves open
The "?" before 1,50,000 (twice, as printed) is the rupee sign. The depreciation method is not stated; straight line over the 4-year life is read (the old plant's written down value over its remaining life with no salvage value; the new machine's cost less scrap value). The loss on selling the old plant is not taxed, as the question says.
Write it in this order
- Read the data; note exactly what is asked 1 min
- 1 Relevant cash flows: incremental basis, sunk original cost, untaxed loss on sale 1 mark 2 min
- 2 Net initial cash outflow 2 marks 3 min
- 3 Incremental depreciation 1 mark 2 min
- 4 Annual incremental cash flow after tax 3 marks 5 min
- 5 Terminal cash flow and the cash flow statement 1 mark 2 min
- Check: arithmetic, units (₹, %), final answer underlined 1 min
Try it first. About 16 minutes for 8 marks. Write it out, then open the solution.
Solution
Hover or tap a marked figure, like 72,000, to see how it is made and where else it appears.
Basis. This is a replacement decision: a fixed asset is replaced because a newer technology has made it outdated. Only the incremental cash flows that arise because the replacement is made are relevant.
- The old plant's original cost of ₹1,50,000 was paid in the past and cannot be recovered whatever is decided now (a sunk cost), so it is not a cash flow of this decision; its written down value of ₹60,000 matters only for the depreciation it would still have earned.
- Depreciation is a non-cash expense: the incremental depreciation is deducted to find the tax and then added back to the profit after tax.
- Depreciation is straight line over the 4-year life, each machine on its own (paper note).
- The ₹15,000 loss on selling the old plant (written down value ₹60,000 less sale value ₹45,000) is not taxed, as the question directs, so it gives no tax saving.
1. Initial cash outflow (year 0). In a replacement, the cost of the new asset is reduced by the net proceeds from selling the old one.
| Particulars | ₹ |
|---|---|
| Cost of the new machine | 3,20,000 |
| Less: sale value of the old plant today | 45,000 |
| Net initial cash outflow | 2,75,000 |
| Machine | Depreciable amount (₹) | Life (years) | Annual depreciation (₹) |
|---|---|---|---|
| New machine: 3,20,000 − scrap 42,000 | 2,78,000 | 4 | 69,500 |
| Old plant: written down value, nil salvage at the end | 60,000 | 4 | 15,000 |
| Incremental depreciation | 54,500 |
3. Annual incremental operating cash flow after tax (years 1 to 4). The change in income before tax, less the change in tax, plus the change in depreciation.
| Particulars | ₹ |
|---|---|
| Additional annual benefit before depreciation and tax | 1,50,000 |
| Less: incremental depreciation | 54,500 |
| Incremental profit before tax | 95,500 |
| Less: tax @ 35% | 33,425 |
| Incremental profit after tax | 62,075 |
| Add: incremental depreciation | 54,500 |
| Incremental cash flow after tax | 1,16,575 |
4. Terminal cash flow (end of year 4). The final salvage value is added to the last year's operating cash flow. The new machine's scrap value is ₹42,000; the old plant would have been worth nothing by then, so the whole ₹42,000 is incremental. It equals the new machine's book value at the end of year 4, so there is no gain or loss to tax.
Cash flows of the replacement decision
| Year | Initial outlay (₹) | Operating CFAT (₹) | Scrap value (₹) | Net cash flow (₹) |
|---|---|---|---|---|
| 0 | (2,75,000) | — | — | (2,75,000) |
| 1 | — | 1,16,575 | — | 1,16,575 |
| 2 | — | 1,16,575 | — | 1,16,575 |
| 3 | — | 1,16,575 | — | 1,16,575 |
| 4 | — | 1,16,575 | 42,000 | 1,58,575 |
Conclusion. Replacing the plant needs a net outlay of ₹2,75,000 now and yields incremental cash inflows of ₹1,16,575 a year for years 1 to 3 and ₹1,58,575 in year 4 (₹1,16,575 plus the ₹42,000 scrap value). No discount rate is given, so the question asks for the cash flows only; they are the inputs for an NPV or IRR appraisal.
Where the 8 marks sit
| # | Component | Marks |
|---|---|---|
| 1 | Relevant cash flows: incremental basis, sunk original cost, untaxed loss on sale | 1 |
| 2 | Net initial cash outflow | 2 |
| 3 | Incremental depreciation | 1 |
| 4 | Annual incremental cash flow after tax | 3 |
| 5 | Terminal cash flow and the cash flow statement | 1 |
| Total | 8 |
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